Defence giant BAE Systems disappointed the market yesterday, after it said
revenues are expected to fall in the current year. However, profits are
still expected to rise in 2011 as efficiency measures kick in.

Forecasts are likely to come down, but one thing that investors need to consider is the strength of BAE's balance sheet and the amount of cash the company has to make strategic purchases over the next few years.

Defence budgets may be tight at the moment, but the world is not becoming a safer place. Indeed, history shows that Western governments often tend to end up regretting cutting defence spending and eventually have to make bigger outlays to catch up.

BAE is currently reducing the volume in its Land & Armaments unit, which manufactures combat and tactical vehicles. This is a sensible move, given the likely reduction in government budgets for these products over the next few years.

However, the company is making strategic inroads in important new markets such as India and Brazil, which will reap rewards over the longer term.

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The 2010 numbers also saw a one-off £100m charge for the cancellation of a ship contract with Trinidad and Tobago. This is non-recurring so, along with cost-cutting measures, this should help with next year's figures.

The 2010 accounts were actually pretty robust, given the uncertain backdrop. In the 12-month period to December 31, revenues rose to £21.1bn from £20.4bn and pre-tax profits recovered to £1.4bn from £266m. In 2009, BAE took a number of charges, so this is the reason profits have jumped. There was a £973m impairment charge on the acquisition of Armor Holdings, which included £592m relating to the loss of a US Army trucks contract.

George Rose, BAE's outgoing finance director, leaves the group's balance sheet in rude health. The company has net debt of just £242m – and it generated £1.5bn in cash from its operations last year. For a company of its size this can be regarded as underleveraged, but that is not a bad position to be in at the moment.

The cash-generative nature of the business has allowed for an increase in the group's dividend. The final dividend, payable on June 1, is 10.5p, up from 9.6p last year, bringing the total dividend for the year to 17.5p. This represents a full-year increase of 9.4pc.

The payment is covered by earnings 2.3 times and BAE says that it wants a long-term sustainable earnings cover of approximately two times. This means there is plenty of scope to increase the payment in the current year – and in the future when earnings recover from the current crisis. Buy-backs are also a possibility, which will also be a boost for shareholders.

The prospective dividend yield this year is a very attractive 5.3pc, rising to 5.6pc in 2012.

Profits will also be helped by the group's reorganisation to cut costs, after its headcount was reduced by about 15,000 over the past two years. This figure includes contractors.

The company is refocusing part of its business by moving into more intelligence-based services. For example, its Detica unit specialises in security intelligence analysis and cyber-terrorism. Indeed, the company has about £600m of acquisitions expected to complete in the first half.

The shares are trading on a December 2010 earnings multiple of 7.9 times, falling to 7.7 next year.

They were named as one of Questor's tips of the year last year on January 1 at 359½p and they are now 5pc below the recommendation price, compared with a FTSE 100 up 10pc, although Questor has recommended them as a buy as low as 300p.

The valuation still looks compelling from a value point of view and the shares remain a solid yield play with medium-term recovery potential. Buy.